This report addresses the financial instability in developing countries and the Korean economy.   
The financial markets of developing countries are showing signs of instability -- falling stock prices, and rising exchange rates and interest rates) as foreign investment in their securities shrinks due to the possibility of an earlier than expected tapering of quantitative easing. The Jakarta Composite Index is down 22.9% from its peak, and the Indonesian rupiah fell 11.9% (from May 22 to August 27). The BSE 30 stock price index plummeted 9.0%, and the Indian rupee lost 18.0% of its value. Developing countries and developed countries seem to be diverging for the time being in their performance as the latter show indications of strengthening.    
The adverse effects of financial jitters in developing countries on Korea's economy are likely to be short-term and limited, for several reasons. For one, most developing countries maintain high foreign reserves, and the vast improvement in their current account balances and fiscal balances since the Asian financial crisis in 1997 means that they are much better able to absorb external shocks. It is, therefore, highly unlikely that financial market turmoil in some countries will spill over into other countries. However, Korea's exports to developing countries may suffer in the short term since the financial market instability in India and Indonesia has led to an economic slowdown in some developing economies.    Second, the US economy is expected to continue expanding because the extent and timing of tapering of quantitative easing by the US Federal Reserve hinge on the strength of the US economic recovery. With the developed countries' demand for imports gradually improving on the strength of the economic rebound of the US and the eurozone's rise out of recession, developing economies should experience a business upturn.  (As an economic growth rate of 1% in advanced countries is assumed to lead to that of 0.92% in developing countries; IMF, assumed elasticity between 2000 and 2011)
Third, as quantitative easing in the eurozone and Japan is projected to continue for a substantial period of time despite the tapering of quantitative easing in the US,  global liquidity is unlikely to contract sharply .  
In conclusion, the financial turmoil in some developing countries will likely cause Korea's economic recovery to slow for a short time, but will not have a significant effect on the overall recovery. Nevertheless, the recurring financial jitters in some developing economies will likely reinforce domestic investors' propensity to invest for the  short term and their flight to quality for the time being. This may increase financing costs for domestic SMEs with low credit ratings or unstable revenue streams (or households with low credit ratings and low incomes) or create a bottleneck in their cash flow due to the imposition of tougher requirements for credit guarantees. The tighter global liquidity, the stronger dollar, the economic slowdown in developing countries, and other factors will likely cause prices of global commodities to trend somewhat downward, and this should help keep domestic prices stable and improve the trade balance.  


Won Dongah